LONDON (Reuters) - European Union regulation intended to ensure hedge funds and private equity groups cannot threaten the global financial system by being "too big to fail" could end up having the opposite effect.
Critics of the EU's Alternative Investment Fund Managers Directive (AIFMD), which is expected to be finalised within weeks, say that rather than drawing secretive asset managers into the regulatory net as its architects intended, it will actually concentrate risk in fewer hands.
The fear among many in the multi-billion dollar industry and some of their advisors is that the cost of complying with the rules could drive some smaller fund managers out of business or force them out of Europe where the rules do not apply and where they can continue to trade without scrutiny.
Mats Persson, director of independent think tank Open Europe, which analyses EU policy, has some sympathy with this view.
"The AIFMD will boost transparency, which is good, and that is something the industry must learn how to live with. But I cannot see how a lot of these other aspects are going to make the market safer at all," he said.
A hedge fund running just a few thousand pounds in assets is theoretically capable of suffering losses far greater than the cash it manages, by mistiming or miscalculating bets.
Hedge fund managers have not been obliged to share the finer details of their trades with anyone. This anonymity means market participants often have no idea who they are betting against, let alone how capable they are of paying out on a failed bet.
If one manager cannot pay out on a trade, it could spark a chain reaction of losses in the portfolio of the investor on the other side of the deal. Authorities fear such a failure could cripple confidence across financial markets, as happened when U.S. bank Lehman Brothers collapsed in 2008.
A central plank of the new rules, which will be brought in from July, involves money managers who market funds in the EU being required to work with independent depositaries.
These are banks that, for a fee, track what the manager does with clients' money and agree to cover investor losses in the event of unauthorised trading.
Appointing a depositary is supposed to prevent a repeat of last year's MF Global debacle, in which $1.6 billion of client assets were allegedly used to top up bad bets that the now-bankrupt broker had struck with its own money.
But it remains unclear how many funds or managers these financial custodians will be willing to backstop, or how much they might charge for the service.
"Depositaries have been pointing out that they are not insurers. They cannot have unlimited liability on their balance sheets," said Rory Gage, a director at financial consultant Navigant, pointing out the huge responsibilities faced by custodians like State Street Global Advisors and BNY Mellon.
Depositaries may charge fund managers high fees to take on these risks. The Alternative Investment Managers Association (AIMA) estimates the regulations will cost its industry as much as 6 billion euros ($7.71 billion), mostly due to depositary fees.
Compliance costs are likely to add to the pressures on funds following a phase of poor performance and client exits.
While the focus on transparency, demanded in the aftermath of the 2008 banking crisis and the collapse of the multi-billion dollar Ponzi scheme run by hedge fund fraudster Bernard Madoff, has been welcomed, commentators point out the rules will not avert losses when authorised trades turn sour.
Stefaan De Rynck, a spokesman for Michel Barnier, the EU financial services commissioner who championed the directive, says the critics' fears are unfounded.
"We need stronger rules for hedge funds. Many investors lost their money because of failing regulation and practices. At times, no one seemed to monitor the use of investors' money, or the value of investment titles," he said.
"The EU is taking similar measures as in the US and other countries around the world to put stronger rules in place to allow hedge funds to operate with sound standards and practices."
Charles Muller, head of investment management regulation at KPMG, pointed to a chink in the rules that fund managers could use to their advantage.
If managers fail to comply with the directive, or choose to move some of their funds to a non-EU regulated domicile, they will forfeit the right to market products across the EU.
But funds will still be allowed to place units with investors privately and sell funds to clients who seek out investments under a loophole known as 'reverse solicitation'.
Echoing tactics used to curb excessive risk-taking at bailed-out banks, the rules will also force asset managers to rein in performance-related pay giving them yet another reason to think about quitting the EU.
"The loser is the investor, the precise person regulators are trying to protect. It is not clear at all how AIFMD is going to tackle any systemic risk issues," said Nicola Meaden Grenham, co-founder of Irish-based consultant Dumas Capital.
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Additional reporting by Huw Jones, Laurence Fletcher and Kathrin Jones in Frankfurt; Editing by Alexander Smith and Erica Billingham